The Gordon Growth Model: Formula & Examples

Instructor: James Blackburn

James has an MBA from Auburn University and a MA in Humanities from Cal State-Dominguez Hills He writes on leadership, business strategy and finance.

In this lesson, we will learn how stocks are valued using the Gordon Growth Model. We will identify the assumptions required in the model. We will also review an example calculation using the model.

Investing

Stock investing is a risky business. Still, investing in stocks can be a good personal financial decision, that is, if we follow a few rules. First, diversify your stock portfolio with a large mix of stable growth stock and a small mix of potential winners. Then, hold stock for an average of five to ten years before you sell. Finally, and most important, purchase stock at the right price.

Consider a company with stock valued at $45 and rising $1 every two weeks. An inexperienced investor may purchase the stock at $45 with the expectation that the price will continue to rise at this rate. However, at some point, the stock will top out and a massive sell-off will begin. This sell-off causes the stock price to fall rapidly. In most cases, the rate of decline is much faster than the rate of increase.

Before you invest, do your homework. Review the annual report, compare industry trends, and calculate dividend growth. Using these things along with the Gordon Growth Model will help determine whether the stock is worth your investment. The Gordon Growth Model uses dividend growth and rate of return to determine an objective value of a company's stock. Let's examine the model in more detail.

Stability: Profit and Loss Analysis

The Gordon Growth Model requires that a company is stable. You should evaluate the stability of the company before using the model. Common analysis, the process of comparing the the current year to a base year, is a great place to start. A comparison using dollars can be confusing. Instead, convert the current year into a percentage with respect to the base year.

You can use the formula below to help determine growth rates. Let's assume 2016 Total Revenue (Revenue Year 2) is $450 million and the 2015 Total Revenue (Revenue Year 1) is $400 million.

RG Model

The revenue growth year over year period is 12.5%. The same formula can be used to calculate total expenses, net income and dividend growth. In fact, dividend growth is used in the valuation of stock.

Dividend Growth

Dividend growth is one important metric when determining a stock's true value. Dividends are payments made to stockholders. It's important to check the dividend policy, not all companies pay dividends. Those that do may pay them quarterly, semi-annually, or annually.

Investors view these payments as returns on their investment. If a company's stock price is $45 and it pays an annual divided of $1.50, then the dividend is 3.3 % of the stock price. If over the past five years, the dividend has increased by 6% each year, then the growth rate of the dividend is 6%. If the dividend growth is driven by higher profits resulting from market growth, and the company is reinvesting in the business, then the outlook for that company is good. The formula below shows a one year growth calculation.

DG Example

Gordon Growth Model

The Gordon Growth Model, sometimes referred to as the Dividend Growth Model, uses the investor's required rate of return and the dividend growth rate to determine the value of the stock. The stock price (P) is equal to the expected value of the dividend (D1) divided by the difference between the investor's rate of return (r) minus the constant growth rate of the dividend (g).

Gordon Model

The rate of return (r) is the required rate of return from an investor. You could use the average return from one of the index funds such as the S&P 500. The S&P 500 is an index comprised of 500 different stocks. If you, as an investor, were to invest in the stocks in this index, you would have received an average return on your investment of 15.08% over the past 5 years. After removing one year of unusually high returns to be conservative, the average growth rate is 9.02%. Since, we can invest in the market and receive a 9% growth rate, we would expect a rate of return greater than the market 9%. As an investor we could establish our rate of return (r) at 10%.

Gordon Growth Example

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